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Utility companies – The Warren Buffet perspective

In 2012, I sold my two utility stocks EVN and Fortum because I realised that I didn’t really understand the business model. I looked a little bit more general into utilities here, but with no real results. However,at least in Europe, the utility sector looks like one of the few remaining “cheap” sector.

If you don’t know a lot about a sector but need to start somewhere,it is always a good idea to look ifWarren Buffet has something to say about it

Although mostly his well-known consumer good investments like Coca Cola and Gilette are mentioned, Buffet runs a quite sizable utility operation called MidAmerican Energy.

We have two very large businesses, BNSF and MidAmerican Energy, that have important common characteristics distinguishing them from our many other businesses. Consequently, we assign them their own sector in this letter and also split out their combined financial statistics in our GAAP balance sheet and income statement.
A key characteristic of both companies is the huge investment they have in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire. Our credit is not needed: Both businesses have earning power that even under terrible business conditions amply covers their interest requirements.

At MidAmerican, meanwhile, two key factors ensure its ability to service debt under all circumstances: The stability of earnings that is inherent in our exclusively offering an essential service and a diversity of earnings streams, which shield it from the actions of any single regulatory body.

I would argue he second point is interesting: Diversification in utilities works across regulators, not necessarily geographic location.

What I found extremely interesting is that Buffet is allocating a lot of capital to the utility sector. Out of the 19 bn USD Capex in Berkies operating businesses from 2009-2011, MidAmerican Capex summed up to ~9 bn USD, so almost half of Berkies total Capex.

One can assume that Buffet is not making all share investment decisions nowadays, but I think capital allocation to operating companies will be still made by him personally.

Buffet seems also quite interested in renewable energy, as the following comment from the annual report shows:

MidAmerican will have 3,316 megawatts of wind generation in operation by the end of 2012, far more than any other regulated electric utility in the country. The total amount that we have invested or committed to wind is a staggering $6 billion. We can make this sort of investment because MidAmerican retains all of its earnings, unlike other utilities that generally pay out most of what they earn. In addition, late last year we took on two solar projects – one 100%-owned in California and the other 49%-owned in Arizona – that will cost about $3 billion to construct. Many more wind and solar projects will almost certainly follow.

Here, he also mentions that he doesn’t extract any dividends out of his utility group. He considers it a growth opportunity rather than a cash cow. I think this is also worth keeping in mind, as many investors would judge utility stocks mainly by dividend yield.

From the 2009 report we learn the following:

Our regulated electric utilities, offering monopoly service in most cases, operate in a symbiotic manner with the customers in their service areas, with those users depending on us to provide first-class service and invest for their future needs. Permitting and construction periods for generation and major transmission facilities stretch way out, so it is incumbent on us to be far-sighted. We, in turn, look to our utilities’ regulators (acting on behalf of our customers) to allow us an appropriate return on the huge amounts of capital we must deploy to meet future needs. We shouldn’t expect our regulators to live up to their end of the bargain unless we live up to ours.

This is as clear as it gets. Utilities are a “natural” monopoly. If you play by the rules (at least in the US), you are guaranteed a decent return.

In the same report Buffet once more explains why he is suddenly more interested in utilities:

In earlier days, Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing amounts of cash, we are today quite
willing to enter businesses that regularly require large capital expenditures.

From the 2008 report, this sentence is reinforcing Buffets strategy:

Indeed, MidAmerican has not paid a dividend since Berkshire bought into the company in early 2000. Its earnings have instead been reinvested to develop the utility systems our customers require and deserve. In exchange, we have been allowed to earn a fair return on the huge sums we have invested. It’s a great partnership for all concerned.

On acquisition of utilities, we can also find his thoughts in that report:

In the regulated utility field there are no large family owned businesses. Here, Berkshire hopes to be the “buyer of choice” of regulators. It is they, rather than selling shareholders, who judge the fitness of purchasers when transactions are proposed.

There is no hiding your history when you stand before these regulators. They can – and do – call their counterparts in other states where you operate and ask how you have behaved in respect to all aspects of the business, including a willingness to commit adequate equity capital.

When MidAmerican proposed its purchase of PacifiCorp in 2005, regulators in the six new states we would be serving immediately checked our record in Iowa. They also carefully evaluated our financing plans and capabilities. We passed this examination, just as we expect to pass future ones.

So being nice and trustworthy to the regulator is what counts in this business.

Finally let’s look at some “hard numbers” from MidAmerican, in order to be able to compare this to other utilities. I will use the MidAmerican 2011 annual report for this.

2011

2010

2009

2008

Total Assets

47.7

45.7

44.7

41.4

Shareholders Equity

14.1

13.2

12.6

10.2

total financial debt

17.8

18.2

19.3

18.2

Sales

11.2

11.1

11.2

12.7

EBIT

2.684

2.502

2.465

2.828

Net Income

1.331

1.238

1.157

1.85

Int. Exp

1.196

1.225

1.257

1.333

Op. CF

3.220

2.759

3.572

2.587

Capex

2.684

2.593

3.413

3.937

ROE

9.8%

9.6%

10.2%

NI margin

11.9%

11.2%

10.3%

14.6%

EBIT Margin

24.0%

22.5%

22.0%

22.3%

Debt/equity

126.2%

137.9%

153.5%

178.4%

EBIT/Int exp

2.24

2.04

1.96

2.12

ROA

2.9%

2.7%

2.7%

We can clearly see that this is low ROA business. Only the significant leverage allows Buffet to have ~10% ROE on average. Additionally, he seems to provide some “contingent” capital to MidAmercian, i.e. to promise a capital contribution of 2 bn USD if required. I think this keeps down the cost of debt without explicitly guaranteeing it. MidAmerican has a credit rating of “only” A- against Berkshire’s AA+. Also one can see that he reduced leverage over the last few years since taking over MidAmerican.

Nevertheless he seems to prefer this vs. returning cash to shareholders. Interesting.

So let’s quickly summarize Warren Buffet’s perspective on utilities as far as I understood it:

– he only started to invest into utilities relatively lately because he needs something where to invest his growing cashflows from the other operations
– he prefers regulated utility business, diversified over different regulators
– he invests a lot of money into renewable energy
– he uses significant leverage to achieve 10% ROE
– he is not looking at the busienss as a cash cow but a long term growth business and therefore does not extract any dividends

Yes, i understand the theory, what i do not understand is… are the WB utilities **in fact building value? …sure the per share book value goes up… but the shareholders can’t eat book value… so… is the only way to make money on a well run utility stock to… TRUST that the market will always pay the same (or better) multiple for that BV and therefore share price will always/usually/sometimes rise in line with BV?

Yes, that is exactly the idea. You have to decide if you want to “eat” your returns now or compound into the future.

Buffet is a very clever capital allocator at berkshire. If he pays the holding a dividend he can buy back berkshire stock, increase cash, invest in one of his other businesses, stocks, bonds or his special deals. For now he seems to prefer investing in his utility subsidiaries.

As long as he thinks he can earn better than average returns he will not pay a dividend to shareholders of berkshire.

ok, forgive me for sounding naive, but if this is the perfect utility investment, then what is the point of investing? you buy something and never pay yourself a dividend… yes, the business grows, and this is reflected in the increasing book value, but if the condition of good growth is that you don’t pay yourself a dividend, then… how do you make money? by selling to someone else who will be happy to own it and never collect a dividend? does this sound like the greater fool theory to you?

Yes, i understand the theory, what i do not understand is… are the WB utilities **in fact building value? …sure the per share book value goes up… but the shareholders can’t eat book value… so… is the only way to make money on a well run utility stock to… TRUST that the market will always pay the same (or better) multiple for that BV and therefore share price will always/usually/sometimes rise in line with BV?

also… what is the good of a rising BV if all cashflows must be reinvested – and they must be because the regulator expects that…. then… the business cannot be said to produce a FREE cashflow, can it?

Buffett also wrote about utilities in the 1984 Annual Letter, with a quip about Consolidated Edison’s “Dig we must” slogan. At that time Buffett wanted businesses with strong economics with no regulation of profits – he recognized that utilities have phenomenal economics, but their social importance has led to government regulation in many countries, often with restrictions on profits. In the 1970s for example, ConEd had to deal with “a punitive regulatory policy (that) was a major factor causing the company’s stock to sell as low as one-fourth of book value”.

My guess is that Buffett is now less concerned with a punitive regulatory policy in the regions where Berkshire’s utilities operate. And maybe he wants a natural outlet for capital that will continue to pile up after he is gone. Also, US insurance was an excellent industry when its pricing was set by regulators (small underwriting profit plus the float for free) – perhaps Buffett has noticed something similar under some utility regulatory regimes.

In the 1970s until the early 1980s, in times of significantly rising inflation, utility companies like American Electric Power (AEP), Commonwealth Edison (now part of Exelon (EXC)), Consolidated Edison (ED), Illinois Power (now part of Ameren Corporation (AEE)), Pacific Gas & Electric (PCG), and Southern Company (SO) were big underperformers in the stock market.

i could not doublecheck the numbers but i don’t thgink that inflation was the problem but higher interest rates. Utilities were often traded like bonds and therefore higher interest rates means lower prices.

Sure, rising bond yields compete with the stock market and especially with utilities.
On the other hand, investors prefer to buy REITs with positive and rising spreads between WACC and cash yield on cost. Rising interest rates have an impact here, too. In addition, the other operating cost.
For utilities, it might be similar.
As you say, rising interest rates would be the real problem.

Its a very interesting topic and I am pretty interested in E.ON AG.
In short and mid term the (german) regulatory issues are serious and not solved easily because the german govermant changes the structure of the energy supply in a major and uncertain way. But with increasing experience in the private sector and on the goverment side the issues are solved surely in the long term. The issues are too important that they could not.
My thesis is:
Does E.ON have pricing power against its customers? Yes; E.ON can increase its product price with upcoming inflation = higher revenue
How would upcoming inflation effect the financials? higher revenue with long term interest payment is constant should create higher FCF + my invested money is inflation proteced (which is, in my opinion, the main motivation for Buffett and Berkshires hugh excess of cash).
Will the current power plant infrastructure needed in > 5-10 years? Yes
Could they profiate from the regulatory impossed “Energiewende” (= structural change in the power supply) in the long term? Yes, it could position it self in profitable strategic position after the structural change.
Could E.ON meet its dept payments (Worst Case Scenario)? I am not sure how they could not and the market does not indicate a likely risk (bonds trading at a premium). In short and mid term are write offs for their failed investments. In long term the economics of energy are in favour for E.ON.
The price trades at a 25% discount to equity book value. Might be a interesting investment?
I have no position in E.ON AG.

One additional point: regulated utilities have only limited pricing power. EON for example had big problems with its gas contracts where they virtually had no pricing power at all and had to eat billions of losses.

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There is no argument that E.on and its infrastructure will be needed for a long time to come. But what will be the economic return on investment? What EU utilities are doing with their assets is crazily unefficient: buying and selling, merging, demerging, switching huge parts of their assets from one company to other ones. This is mostly due to regulations (e.g. E.on had to sell the gas distribution network) and another consequence is that EU utilities need to go far abroad if they want to enlarge their asset base. As E.on can’t buy German gas pipelines, they might build one in India! In the last months we could see the consequences: Turkish, latin american, etc. assets are sold again, because the returns on capital are uncertain and not satisfactory.
How could a small French railway company provide a more efficient and cheaper service on German rails (which they have to rent from Deutsche Bahn)? First they need to establish legal offices, service call centers etc. etc. and in the end they might operate only a few 100 km of rails… How can this be cost efficient? Yet it already happens.
If I were interested in the hidden gems among utilities I would focus on very small companies (MVV Energie? – Not really cheap right now…) which still have room to grow and might profit from regulations that force the big players to sell their assets. Or maybe look into smaller, probably more monopolistic markets (Switzerland? Scandinavia?). I don’t know so well the Uk market, but probably it has smarter regulations in place (Mid-American owns some assets there). But I’d stay away from companies that rely on public-private partnerships like Veolia.

@Tobias: The regulatory issues are important. I cannot proof it, because the political process to solve these issues containing too much uncertainty. My thesis is: the solution will not be too good or too bad and the big utilities will have their “fair” share in the political compromise through lobbying. Small utilities cannot not operate big power plants which are needed for the industry. On the other hand I do not expect further anti-oligopol regulation in the power grid, because the power grid has become seriously unstable.The failed investments abroad are typically over confidence / outside the cicle of competence management mistakes… the only good thing about it is, with further write-offs, the price “hopefully” becomes more depressed.

@mmi: I am not a big fan either but it seems to be a low risk value play and rule no. 1 and 2 is “do not loose money”. Seeing forward to read your thoughs!

It would be interesting to read a follow-up on this really interesting overview, comparing the European situation to the US situation.
It has always struck me as totally crazy that EU burocrats want French utilities to compete on German soil and vice versa. That’s why now we have great tech installed in the middle of the North Sea, but without the cables to bring the energy back to our country, because not only the wind park is built by lots of different European companies – even the cables will be installed by a Dutch one. And the solution is that German taxpayers will refund these businesses in the event of big losses (which are caused by their own failures and by those of their regulators).
Utilities must operate as monopolies to be most efficient and to provide the cheapest energy possible. Regulators should work for preventing them from charging consumers too much for their service. The interesting lesson of your overview is that not even in the supercapitalistic USA politicians think that utilities operate the best way in a regime of free competition.
EU utility stocks are certainly very cheap right now, but there are strong and durable reasons, unfortunately. They are used as cashcows (so they can’t compound), they have to fight competition, some go far abroad to run isolated operations (with huge cost inefficiencies). I’ll stay away from the sector.

For me this means Buffet is/was not optimistic about the performance of publicly traded companies. One of the best stockpickers seems to prefer investing in utilities with save but average returns. With his cost of capital due to float he is poised to make a profit.

if you do CFO(operating working capital + gross PPE + leases capitalized at 8x), the average return on capital becomes ~8.6% over the past 6 years, which I think is more indicative of the long-term economics of this business. Leverage allows him to earn his 15%.

I guess what I’m saying is that the relationship that matters is that between the amount of cash that MAH generates in relation to the amount of cash invested in the business. So Op. CF / Undepreciated Operating Assets is a more accurate reflection of the economics of MAH than ROA tout simple. And ~8.5% is a fairere reflection of its ROC than 3%.

Buffett (still) wants 15% returns on his investments and he wants those returns to be inflation-protected. I think MAH achieves both objectives (as does BNSF).